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1.8 Schools of Thought in Macroeconomics After Keynes

According to Johnson (1971), ‘by far the most helpful circumstance for the

rapid propagation of a new revolutionary theory is the existence of an established

orthodoxy which is clearly inconsistent with the most salient facts of

reality’. As we have seen, the inability of the classical model to account

adequately for the collapse of output and employment in the 1930s paved the

way for the Keynesian revolution. During the 1950s and 1960s the neoclassical

synthesis became the accepted wisdom for the majority of economists

(see Chapter 3). The work of Nobel Memorial Laureates James Tobin, Lawrence

Klein, Robert Solow, Franco Modigliani, James Meade, John Hicks

and Paul Samuelson dominated the Keynesian school and provided intellectual

support for the view that government intervention in the form of demand

management can significantly improve the performance of the economy. The

‘New Economics’ adopted by the Kennedy administration in 1961 demonstrated

the influence of Keynesian thinking and the 1962 Economic Report of

the President explicitly advocated stabilization policies with the objective of

keeping ‘overall demand in step with the basic production potential of the


During the 1970s this Keynesian approach increasingly came under attack

and was subjected to the force of two ‘counter-revolutionary’ approaches,

namely monetarism and new classical macroeconomics. Both of these approaches

are underpinned by the belief that there is no need for activist

stabilization policy. The new classical school in particular supports the view

that the authorities cannot, and therefore should not, attempt to stabilize

fluctuations in output and employment through the use of activist demand

management policies (Lucas, 1981a).

As we shall discuss in Chapter 4, in the orthodox monetarist view there is

no need for activist stabilization policy (except in extreme circumstances)

given the belief that capitalist economies are inherently stable, unless disturbed

by erratic monetary growth. Monetarists hold that when subjected to

some disturbance the economy will return, fairly quickly, to the neighbourhood

of the ‘natural’ level of output and employment. Given this view they

question the need for stabilization policy involving the ‘fine-tuning’ of aggreUnderstanding

gate demand. Even if there were a need, monetarists argue that the authorities

can’t stabilize fluctuations in output and employment due to the problems

associated with stabilization policy. These problems include those posed by

the length of the inside lag associated with fiscal policy, the long and variable

outside time lags associated with monetary policy and uncertainty over what

precise value to attribute to the natural rate of unemployment. In consequence

monetarists argue that the authorities shouldn’t be given discretion to

vary the strength of fiscal and monetary policy as and when they see fit,

fearing that they could do more harm than good. Instead, monetarists advocate

that the monetary authorities should be bound by rules.

With hindsight two publications were particularly influential in cementing

the foundations for the monetarist counter-revolution. First there is Friedman

and Schwartz’s (1963) monumental study, A Monetary History of the United

States, 1867–1960. This influential volume presents persuasive evidence in

support of the monetarist view that changes in the money supply play a

largely independent role in cyclical fluctuations. Second is Friedman’s (1968a)

American Economic Review article on ‘The Role of Monetary Policy’ in

which he put forward the natural rate hypothesis and the view that there is no

long-run trade-off between inflation and unemployment. The influence of

Friedman’s article was greatly enhanced because it anticipated the events of

the 1970s and, in particular, predicted accelerating inflation as a consequence

of the repeated use of expansionary monetary policy geared to over-optimistic

employment targets.

During the 1970s a second counter-revolution took place associated with

new classical macroeconomics. This approach, which cast further doubt on

whether traditional Keynesian aggregate demand management policies can

be used to stabilize the economy, is often seen as synonymous with the work

of one of Friedman’s former University of Chicago students, the 1995 Nobel

Memorial Laureate, Robert E. Lucas Jr. Other leading advocates of the new

classical monetary approach to analysing economic fluctuations during the

1970s include Thomas Sargent, Neil Wallace, Robert Barro, Edward Prescott

and Patrick Minford (see Hoover, 1988; Snowdon et al., 1994).

As we will discuss in Chapter 5, by combining the rational expectations

hypothesis (first put forward by John Muth in the context of microeconomics

in the early 1960s), the assumption that markets continuously clear, and

Friedman’s natural rate hypothesis, Lucas was able to demonstrate in his

1972 Journal of Economic Theory paper on ‘Expectations and the Neutrality

of Money’ how a short-run equilibrium relationship between inflation and

unemployment (Phillips curve) will result if inflation is unanticipated due to

incomplete information.

In line with the monetarist school, new classical economists believe that

the economy is inherently stable, unless disturbed by erratic monetary growth,

and that when subjected to some disturbance will quickly return to its natural

level of output and employment. However, in the new classical approach it is

unanticipated monetary shocks that are the dominant cause of business cycles.

The new classical case against discretionary policy activism, and in

favour of rules, is based on a different set of arguments to those advanced by

monetarists. Three insights in particular underlie the new classical approach.

First, the policy ineffectiveness proposition (Sargent and Wallace, 1975, 1976)

implies that only random or arbitrary monetary policy actions undertaken by

the authorities can have short-run real effects because they cannot be anticipated

by rational economic agents. Given that such actions will only increase

the variation of output and employment around their natural levels, increasing

uncertainty in the economy, the proposition provides an argument against

discretionary policy activism in favour of rules (see Chapter 5, section 5.5.1).

Second, Lucas’s (1976) critique of economic policy evaluation undermines

confidence that traditional Keynesian-style macroeconometric models can be

used to accurately predict the consequences of various policy changes on key

macroeconomic variables (see Chapter 5, section 5.5.6). Third, Kydland and

Prescott’s (1977) analysis of dynamic time inconsistency, which implies that

economic performance can be improved if discretionary powers are taken

away from the authorities, provides another argument in the case for monetary

policy being conducted by rules rather than discretion (see Chapter 5,

section 5.5.3).

Following the demise of the monetary-surprise version of new classical

macroeconomics in the early 1980s a second phase of equilibrium theorizing

was initiated by the seminal contribution of Kydland and Prescott (1982)

which, following Long and Plosser (1983), has come to be referred to as real

business cycle theory. As we shall discuss in Chapter 6, modern equilibrium

business cycle theory starts with the view that ‘growth and fluctuations are

not distinct phenomena to be studied with separate data and analytical tools’

(Cooley and Prescott, 1995). Proponents of this approach view economic

fluctuations as being predominantly caused by persistent real (supply-side)

shocks, rather than unanticipated monetary (demand-side) shocks, to the

economy. The focus of these real shocks involves large random fluctuations

in the rate of technological progress that result in fluctuations in relative

prices to which rational economic agents optimally respond by altering their

supply of labour and consumption. Perhaps the most controversial feature of

this approach is the claim that fluctuations in output and employment are

Pareto-efficient responses to real technology shocks to the aggregate production

function. This implies that observed fluctuations in output are viewed as

fluctuations in the natural rate of output, not deviations of output from a

smooth deterministic trend. As such the government should not attempt to

reduce these fluctuations through stabilization policy, not only because such

attempts are unlikely to achieve their desired objective but also because

reducing instability would reduce welfare (Prescott, 1986).

The real business cycle approach conflicts with both the conventional

Keynesian analysis as well as monetarist and new classical monetary equilibrium

theorizing where equilibrium is identified with a stable trend for the

natural (full employment) growth path. In the Keynesian approach departures

from full employment are viewed as disequilibrium situations where societal

welfare is below potential and government has a role to correct this macroeconomic

market failure using fiscal and monetary policy. In sharp contrast

the ‘bold conjecture’ of real business cycle theorists is that each stage of the

business cycle, boom and slump, is an equilibrium. ‘Slumps represent an

undesired, undesirable, and unavoidable shift in the constraints that people

face; but, given these constraints, markets react efficiently and people succeed

in achieving the best outcomes that circumstances permit … every stage

of the business cycle is a Pareto efficient equilibrium’ (Hartley et al., 1998).

Needless to say, the real business cycle approach has proved to be highly

controversial and has been subjected to a number of criticisms, not least the

problem of identifying negative technological shocks that cause recessions.

In Chapter 6 we shall examine these criticisms and appraise the contribution

that real business cycle theorists have made to modern macroeconomics.

The new classical equilibrium approach to explaining economic fluctuations

has in turn been challenged by a revitalized group of new Keynesian

theorists who prefer to adapt micro to macro theory rather than accept the

new classical approach of adapting macro theory to orthodox neoclassical

market-clearing microfoundations. Important figures here include George

Akerlof, Janet Yellen, Olivier Blanchard, Gregory Mankiw, Edmund Phelps,

David Romer, Joseph Stiglitz and Ben Bernanke (see Gordon, 1989; Mankiw

and Romer, 1991). As we will discuss in Chapter 7, new Keynesian models

have incorporated the rational expectations hypothesis, the assumption that

markets may fail to clear, due to wage and price stickiness, and Friedman’s

natural rate hypothesis. According to proponents of new Keynesian economics

there is a need for stabilization policy as capitalist economies are

subjected to both demand- and supply-side shocks which cause inefficient

fluctuations in output and employment. Not only will capitalist economies

fail to rapidly self-equilibrate, but where the actual rate of unemployment

remains above the natural rate for a prolonged period, the natural rate (or

what new Keynesians prefer to refer to as NAIRU – non-accelerating inflation

rate of unemployment) may well increase due to ‘hysteresis’ effects.

As governments can improve macroeconomic performance, if they are given

discretion to do so, we also explore in Chapter 7 the new Keynesian approach

to monetary policy as set out by Clarida et al. (1999) and Bernanke

et al. (1999).

Finally we can identify two further groups or schools of thought. The Post

Keynesian school is descended from some of Keynes’s more radical contemporaries

and disciples, deriving its inspiration and distinctive approach from

the writings of Joan Robinson, Nicholas Kaldor, Michal Kalecki, George

Shackle and Piero Sraffa. Modern advocates of this approach include Jan

Kregel, Victoria Chick, Hyman Minsky and Paul Davidson, the author of

Chapter 8 which discusses the Post Keynesian school. There is also a school

of thought that has its intellectual roots in the work of Ludwig von Mises and

Nobel Memorial Laureate Friedrich von Hayek which has inspired a distinctly

Austrian approach to economic analysis and in particular to the

explanation of business cycle phenomena. Modern advocates of the Austrian

approach include Israel Kirzner, Karen Vaughn and Roger Garrison, the

author of Chapter 9 which discusses the Austrian school.

To recap, we identify the following schools of thought that have made a

significant contribution to the evolution of twentieth-century macroeconomics:

(i) the orthodox Keynesian school (Chapter 3), (ii) the orthodox monetarist

school (Chapter 4), (iii) the new classical school (Chapter 5), (iv) the real

business cycle school (Chapter 6), (v) the new Keynesian school (Chapter 7),

(vi) the Post Keynesian school (Chapter 8) and (vii) the Austrian school

(Chapter 9). No doubt other economists would choose a different classification,

and some have done so (see Cross, 1982a; Phelps, 1990). For example,

Gerrard (1996) argues that a unifying theme in the evolution of modern

macroeconomics has been an ‘ever-evolving classical Keynesian debate’ involving

contributions from various schools of thought that can be differentiated

and classified as orthodox, new or radical. The two ‘orthodox’ schools, ‘IS–

LM Keynesianism’ and ‘neoclassical monetarism’, dominated macroeconomic

theory in the period up to the mid-1970s. Since then three new schools have

been highly influential. The new classical, real business cycle and new

Keynesian schools place emphasis on issues relating to aggregate supply in

contrast to the orthodox schools which focused their research primarily on

the factors determining aggregate demand and the consequences of demandmanagement

policies. In particular, the new schools share Lucas’s view that

macroeconomic models should be based on solid microeconomic foundations

(Hoover, 1988, 1992). The ‘radical’ schools, both Post Keynesian and Austrian,

are critical of mainstream analysis, whether it be orthodox or new.

We are acutely aware of the dangers of categorizing particular economists

in ways which are bound to oversimplify the sophistication and breadth of

their own views. Many economists dislike being labelled or linked to any

specific research programme or school, including some of those economists

listed above. As Hoover (1988) has observed in a similar enterprise, ‘Any

economist is described most fully by a vector of characteristics’ and any

definition will ‘emphasise some elements of this vector, while playing down

related ones’. It is also the case that during the last decade of the twentieth

century, macroeconomics began to evolve into what Goodfriend and King

(1997) have called a ‘New Neoclassical Synthesis’. The central elements of this

new synthesis involve both new classical and new Keynesian elements, namely:

1. the need for macroeconomic models to take into account intertemporal


2. the widespread use of the rational expectations hypothesis;

3. recognition of the importance of imperfect competition in goods, labour

and credit markets;

4. incorporating costly price adjustment into macroeconomic models.

Therefore, one important development arising from the vociferous debates of

the 1970s and 1980s is that there is now more of a consensus on what

constitutes a ‘core of practical macroeconomics’ than was the case 25 years

ago (see Blanchard, 1997b, 2000; Blinder, 1997a; Eichenbaum, 1997; Solow,

1997; Taylor, 1997b).

With these caveats in mind we will examine in Chapters 3–9 the competing

schools of macroeconomic thought identified above. We also include interviews

with some of the economists who are generally recognized as being

leading representatives of each group and/or prominent in the development of

macroeconomic analysis in the post-war period. In discussing these various

schools of thought it is important to remember that the work of Keynes

remains the ‘main single point of reference, either positive or negative, for all

the schools of macroeconomics’. Therefore, it is hardly surprising that all the

schools define themselves in relation to the ideas originally put forward by

Keynes in his General Theory, ‘either as a development of some version of

his thought or as a restoration of some version of pre-Keynesian classical

thought’ (Vercelli, 1991, p. 3).

Before considering the central tenets and policy implications of these main

schools of thought we also need to highlight two other important changes that

have taken place in macroeconomics during the final decades of the twentieth

century. First, in section 1.9 we outline the development of what has come to

be known as the new political macroeconomics. The second key change of

emphasis during the last 20 years, reviewed in section 1.10, has been the

renaissance of growth theory and empirics.